Wednesday, March 28, 2012

Mainstream economists believe that since for every buyer there is a seller, they take this logic to the notion of bank lending, and assume that for every borrower, there is a lender, with banks just bringing them together. And they further assume that when a borrower needs to increase his consumption, a lender needs to curtail his, to provide the necessary funds.

Paul Krugman recently asks: "If I decide to cut back on my spending and stash the funds in a bank, which lends them out to someone else, this doesn’t have to represent a net increase in demand. Yes, in some (many) cases lending is associated with higher demand, because resources are being transferred to people with a higher propensity to spend; but Keen seems to be saying something else, and I’m not sure what. I think it has something to do with the notion that creating money = creating demand, but again that isn’t right in any model I understand."

This image of lending is outdated, and does not explain why banks trip over themselves to provide lines of credit to creditworthy customers. Just imagine, you have all those banks that have issued you credit cards, with varying line amounts, whether you actually asked for the card or not. Why did they do it? Because they have tons of unlent funds that they have to lend out? What good is it to them if you don't use your card, if they've already issued you one? They've given you an open commitment to provide you up to your line limit, but it's your option whether to you use it, not use it, partially use it, or use it then pay it down quickly.

If you don't use it, the bank doesn't earn interest from you. If they did secure loanable funds prior to you drawing your line, then what happens to the poor schmuck who provided that loanable fund? No interest income for him. Is there really a schmuck standing ready to not consume by the exact amount that you draw your line with, month after month, and stands ready to forego his interest income once you pay it back? Did the bank promise him something in order to secure his funds? If the loanable funds theory of banking is correct, then credit cards have got to be the most uneconomical bank product ever invented. Any banker worth his salt will push to sell you an actual loan rather than a miserable line of credit. As far as the logic of loanable funds theory is concerned, it's a losing proposition for any bank. So why do banks provide this product, often to people who don't even want it? Does the loanable funds theory have an explanation for this?

Krugman tries to explain why banks do it: "As I (and I think many other economists) see it, banks are a clever but somewhat dangerous form of financial intermediary, one that exploits the law of large numbers to offer a better tradeoff between liquidity and returns, but does so at the cost of taking on very high leverage, with all the risks that entails.The super-high leverage of banks, and the role of bank deposits as a key form of liquid assets, means that banks broadly defined are usually central players in financial crises. But that’s a quantitative thing, not a qualitative thing."

Banks risking insolvency for an uncertain income stream? Does the loanable funds theory have an explanation for this?

Tuesday, March 20, 2012

To give you a better illustration of my point, let’s use Bill Mitchell’s favorite analogy (with due respect) of the buffer stock of heads of cattle. But in this case, let’s use a recurring income transaction of selling milk, which is what would be more closely similar to a wage income stream. Imagine an economy with 1,000 heads of cattle, owned individually by different farmers, all of whom are each other’s customers for the milk. Let’s imagine that each cow can only provide for one customer at a time, each of whom buys a long-term milk stream, say for 5 years.

Now, imagine 200 farmers want to save, so there is demand for only 800 milk streams. This decreases the price of milk, which was say, $100/one year’s delivery, down to $80/year. But then, imagine that a default buyer arrives, and makes an open offer of $100 /year for each undemanded milk stream, thereby increasing total demand back for all 1,000 heads of cattle, and price back to $100.

This default buyer increases the income stream, and therefore, the ‘animal spirits’ of the cattle owners, and they then start demanding other milk-based products. Milk duds, milkshakes, and chocolate milk start becoming a common craving of the now better-off famers. Let’s say 50 farmers now require more than one cow, because they want to expand into these milk goodies, bringing the farmer end user demand to 850 heads.

But since the default buyer keeps his open demand of $100 for all undemanded cows, not all cattle owners are willing to provide his cow to the other farmers now willing to buy more than one cow’s milk stream. Some farmers just got accustomed to the default buyer’s arrangement, perhaps because he is more convenient to transact with. So to attract some of the 200 providing their cows in service of Mr. Default Buyer, these 50 farmers up their offer to $110/year.

30 farmers willingly transfer to the new buyers, leaving 20 more without a cow for their additional demand. Let’s say and additional 10 were willing to pay for up to $115, which entices more farmers to shift, but still leaves 10 new owners unable to make their expansion. 840 cows are now providing milk for other farmers, 160 remain Mr Default’s suppliers.

Now, the farmer cum customers are getting even more prosperous, and demand even more milk-based products. Milk bonbons, cream pies, and designer ice cream now become the “new cool products” to have. This entices more producers to come forward, as the profit margins for these can accommodate the now $115 clearing price for one cow’s year of milk, and then some. Let’ say 80 farmers come forward offering $125. This entices 50 of the 160 remaining suppliers to Mr Default to shift.

That still leaves 30 new producers unable to find suppliers for their new bonbon business. Of those already serving other farmers, 20 indicate they’re willing to transfer again at $145. So 20 of the 30 get their cows, but 20 other farmers that already had cows lose theirs, and the price to get new cows starts at $145. Meanwhile, the 110 that still remain with Mr Default stay with him.

Now what happens when milk-based pastries, cream cocktails, and milk sauces become the norm? Bidding for the remaining 110 cows, or for any of the others willing to transfer from some other farmer customers, probably starts at $170. Maybe Mr Default still will 80 cows left afterwards, but cow inflation has now risen 70%. Time to start tightening.

Just because you put a floor on a price for something does not tell you anything about how high its price will go. Not when you only have a finite supply of that thing. And when someone puts an open offer for all of the supply, the bidding starts higher and proceeds more furiously, whenever there's an expansion of general demand, than when the open offer is withdrawn when other offers are coming to the table.

addendum: Geerusell asks a good follow-up question: “Why are farmers who supply Mr. Default presumed to be so sticky at the $100 level?” - It could be any reason in my mind. He’s easier to deal with, he doesn’t give hell when the cows want to take a cow holiday, is willing to accept a more flexible schedule, work is closer to home…a lot of other reasons. But I can imagine not everyone offered the first higher price will immediate jump on it. A sizeable number won’t jump until.. they’re made an offer they can’t refuse.

Monday, March 19, 2012

Bill Mitchell has a post with a re-exposition of the JG, and this is a repost of some comments I made there trying to clarify the mechanism that ensures workers automatically leave the JG job in an expanding economy. What is the mechanism that ensures workers leave the JG job in an expanding economy? Will the government force people to leave the JG?

As I understand it, MMT proposes the JG program to permanently guarantee a job at a set wage to anyone looking for a job. While I understand the need for a jobs program now, when the rest of the economy is contracting/ hoarding/ deleveraging/ correcting, my concern is for when the JG gets the economy starting, and companies start hiring again.

The JG is proposed to offer the living wage, and I agree, both on the principle of fair pay for a fair day’s work, and that for it to work in increasing aggregate demand, it should be at this level. JG therefore eliminates bad jobs with crappy wages due to competition from the JG, which to me is an appropriate goal.

MMTers claim that this is a “one-off” price level boost. So let’s take this ”one-off” price level boost as a given, and think one step ahead. Since the government will continue to put a demand floor to wages under a JG, any heating up in the private sector results in demand shooting above 100% for labour. During a strong expansion, when more businesses are expanding and therefore hiring, the excess demand the JG maintains for workers makes labour scarcer than necessary, and therefore businesses will need to bid up higher to attract people. The only way new firms attract workers is to drive them ever higher above not only what the JG pays, but above what the first few firms to hire are already paying. The more people a firm needs, the higher the labour clearing price for the firm. The higher the clearing price, either less firms start, or higher inflation ensues.

Keeping the JG in such an expansionary environment risks the JG becoming a negotiating ploy for smart workers who know how to use the system, to extract higher wages than they can otherwise. And remember that we’re already talking about a JG program that pays the living wage, so the STARTING POINT for the private sector is to offer higher than this living wage. This means there’s less room for the private sector expansion before it turns into an inflationary environment that would then need to be curtailed by government.

We then get to the mechanism that MMT claims makes the JG program also a price stability program. Paired with tax and interest rate policy, inflation in this scenario can be slain without increasing unemployment, by increasing rates and taxes, so companies scale back operations and lay people off, or businesses close, and more people go back to the lower paying JG job. For a permanent JG to work, the private sector has to stay only up to a certain size, beyond this, the government starts squashing them to ensure price stability.

Hence, if you’re thinking of starting your business once the economy passes this level, you’re going to have to think again, because government will be expected to tighten soon (not by dropping the JG, but by making it more expensive to maintain a small business). Because the government keeps this floor on labour demand even during the boom times, when the economy gets booming, the boom acceleration will be much faster than if the government had withdrawn its additional demand instead. So again, if you’re a businessman, you’ll likely obsess about where this “certain level’ is at.

This is what I meant when I say a permanently fixed JG economy replaces a buffer stock of unemployed with a buffer stock of failed small businesses. Large companies may weather this price stabilization drive by shedding workers, but smaller businesses will close completely. Since a permanently-fixed JG involves a buffer stock of failed small businesses, banking losses will always follow an increase in this buffer stock due to fighting inflation, and there will be great capital wastage due to the closing up of businesses, selling off of inventories, etc. following this increase. In short, I’m getting that under a JG, both bankers and private entrepreneurs will be reluctant to start or fund new small businesses. Whatever jobs get created going forward will have to come from big business, or the JG itself.

I’m not against the JG as a countercyclical policy, but using it as a price stability mechanism means that 1) it seeks to keep private sector only up to a certain level, and 2) with onset of inflation, its price stability mandate kills a lot of new private sector growth just when it’s gaining momentum, more than if the JG was downscaled instead.

The comparisons of permanent JG and no permanent JG in my mind remain: In a JG-less economy in recession, labour demand can be at 80%, while in a booming economy, it will be at 100%. In a permanently-fixed JG economy, labour demand during recession will be at 100%, while during a boom, it will be at 130%. Inflation-fighting taxation will be a lot harsher in the JG economy with 130% labour demand than in an economy with only 100% labour demand. Government will have to kill more private sector companies when it is trying to get that 30% excess demand back to 100% than when it’s trying to get 100% down to 96%. It seems the need to kill more businesses will be much lower if the JG was instead preemptively scaled down by government when the economy starts growing.

I believe that the JG, contra to many MMTers, will not automatically disappear, without distorting the economy, simply by virtue of JG workers leaving for the private sector. That kind of magical thinking is no different than monetarists believing that increasing money supply automatically increases its velocity. No, the JG ends only with the private sector bidding up wages so as to attract workers away from the JG. If this happens by more than a sufficient level, there would be higher inflation than is acceptable. The JG program, which will also have a price stability mechanism, will not stand idly by. The government under a JG policy will try to get prices back to the government’s stated level by getting people back into the lower wage JG, and away from the private sector. It will do so by all means that make it less profitable for business to thrive – taxation, interest rate policy, whatever, anytime the private sector expands by more than a certain level.

As far as I know, there has been no testing of JG on a significant scale, and perhaps only in certain areas where there really is no interest from private sector to invest. In which case, we really need a JG of some sort in that area. In a previous discussion I had with Tom Hickey, he mentions of places like Iowa, where small business have been permanently wiped out by large businesses. I agree with Tom that in these places a permanent JG could be helpful. These are places where the private sector would normally not invest in because it wouldn't be profitable. But there are other places where a permanent JG could eventually become counter-productive. It cannot be enacted on a similar scale, and permanently, in urban centers where private sector already tends to congregate. It will only end up squashing the grassroots initiative there, and the JG will eventually become an alternative economy unto itself, not a bridge for when private sector is weak. That's why when you propose the JG, it's important to make nuances, and signify how it rolls out by sector and geographic location. It's can't be a one size fits all for the entire country.

Advocating that government stand ready to hire “all ready and willing to work” without regard to the state of the economy is advocating for the monopoly currency issuer to tilt the playing field and compete with the currency-constrained private sector for - if there is an open job offer to everyone - scarce labour resource. In the same way iron is good for an anemic but bad for someone with hemochromatosis, a permanently fixed JG would be good or bad depending on the state of the economy. I’m merely suggesting this program needs to be localized rather than enforced in aggregate, and be flexible depending on what is going on in the economy.

Tom Hickey asks what macro policy solution I would suggest instead and what buffer and price anchor. The stock I could think of using as buffer, as is evident from my position, is the JG itself. A working JG proposal should be flexible either on the 100% employment guarantee, on the JG wage, or on the duration of the program, depending on the overall economy. In times of higher inflation, the JG is what adjusts, either in price (wage) or quantity of its workers. With JG flexibility, during a private sector expansion over-all wages don’t rise as fast, and hence, the boom can probably stay for longer, and the fiscal tightening needed to contain it not as harsh. I don’t have suggestions on price anchor, why change what we use now? Call me neoliberal if that’s what this makes me, but the permanently fixed JG has a tradeoff, as Tom acknowledges, and the tradeoff can just be as damaging economically as a buffer stock of unemployed. Less people may venture into private business creation and may end up relying more on government for many things. If there’s a JG during a recession, then everyone who can hold a job should be able to get a job. But when the private sector is expanding, then the JG should be wound down as a matter of policy, not merely as a passive result of people leaving for higher private sector wages.

Friday, March 9, 2012

Iceland, which had to bail out its banking system in 2008, and therefore now has massive sovereign borrowings and diminished currency stability, has recently been looking to adopt a more stable currency from a strong economy, to regain its standing and respectability to the world. The big winner for most of its inhabitants, it seems, is the Canadian loonie. Iceland, which has about 300,000 population, is easily buffeted by currency headwinds, most especially after the 2008 crisis. And since they already have 59 billion euros foreign denominated debt stemming from the crisis, adopting another foreign currency as their default currency is a problem that's probably moot to most Icelanders.

In general, by adopting the Canadian currency, Iceland imports the Canadian monetary condition (highly stable compared to other countries as of the moment). However, only the Canadian government and Canadian-chartered banks can issue this money. How will local Icelanders get hold of this money, for it to be widely-held enough to be their default currency? In all likelihood, Iceland as a whole will have to incur lots of trade and capital surpluses vis-a-vis Canada. That's the only way the Canadian currency will make its way into Icelandic economy in large amounts. With sufficient amount circulating in their economy, it will then be the currency that Icelanders use to buy daily necessities and pay for their obligations, including borrowings, which will now be Canadian-denominated, and borrowed from Canadian banks. Canada will begin to enjoy the exorbitant privilege the U.S. has had globally, at least with regards to Iceland. For this to work, Canadians will have to massively spend into the Icelandic economy.

I don't think this will be detrimental to Canadians monetary-wise, since as people who've read into MMT know, a monetarily sovereign nation that issues its own currency can issue as much as is necessary to clear all transactions. If it spends more than it earns vis-a-vis a foreign trading partner, what it gets are real goods and services that people will sell in exchange for their fiat currency. There could be a glut of Icelandic products and services into the Canadian economy. Salmon? Fisheries? Aluminum? Spa tourism?

By having the same currency, it makes it easier for Iceland to do business with Canada. It will spur Canadian business investment into Iceland, since there will be no more forex risk. More Canadian-owned factories and shops will sweep into their economy. I can imagine Weston, Metro and Shoppers Drugmart setting up shops all over, without worries of losing on foreign exchange whenever they replenish inventory and repatriate profits. Canadian banks will race to set up the first branch in every desirable corner of Reykjavik, and their corporate parent will have stronger, wider funding base than local Icelandic banks. Ditto for consumer investment to the Iceland economy. If Canadians ever tire of the escalating house prices in Canada's metropolitan cities, they can instead buy a cottage overlooking Mt. Eyjafjallajökull? (I kid) And with the convenience of having the same currency, there would be more Canadian tourism to Iceland, which is 3,700 kms away.

Most importantly, people from outside of both Iceland and Canada, who would shy away from investing in Icelandic krona right now, but would gladly put money in Canadian-denominated investments, would be more open to putting money in the local Icelandic banking system, thereby helping to diminish the still-large risk of bank run similar to what happened in 2008. (However, in the event that investor aversion shifts towards Canadian-denominated assets, Iceland-based banks will suffer as much as those in Canada).

The biggest risk to Iceland adopting the loonie is the loss of currency sovereignty and monetary policy control. By adopting a foreign currency, it's putting itself in the same position Greece put itself in when it decided to adopt a currency its government does not issue. Since it will no longer be issuing its own currency, Iceland will lose its ability to enact large countercyclical programs during recessions. Whenever its government has to deficit spend, it will have to borrow in this foreign-issued currency.

Also, the currency's value will be affected by events happening in economies much larger than its own and in places thousand of miles away. Right now, the strong Canadian currency is buoyed by its most productive and successful province, oil-rich Alberta. Just ask the manufacturers in Ontario, or the fishing industries in the Atlantic provinces, how that's going for them. A stronger currency due to oil exports also makes their own exports more expensive. Unfortunately, unlike oil, what they do export are also sold from places with cheaper currency. But if enough economic integration happens, who's to say that there won't be further integration later on, since economic integration leads to greater need for labour mobility, to make up for the economic dislocation integration creates. Looking at history, Newfoundland adopted the loonie first before it eventually became a Canadian province.

I don't know whether this currency adoption plan will go much further than the talk made so far. The Canadian government has discouraged its ambassador to Iceland from making the speech that was supposed to acknowledge this Icelandic plan. After all, publicly talking about another country adopting your currency seems a bit like gloating, and Canadians think it's not polite. But in any case, should this adoption ever happen, perhaps there comes a day when Icelanders also adopt the Canadian obsession of going shopping in the US whenever the loonie gets stronger.

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"Conventional approaches, unconventional conclusions" on the global finance and economic issues of the day. Rogue Econ has been a banker and financial consultant in several countries. Welcome to my blog.